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Can Bonds Continue to Outperform?

Bonds have topped stocks by a large margin over the past year and over the last 40 years. But historic research conducted by Morningstar sheds a critical light on such future performance.

Bonds have outperformed stocks by a large margin over the past year because of the financial crisis, and they've also roughly matched stocks over the past 40 years.

But Peng Chen and Roger Ibbotson of Morningstar show in a recent report that stock returns over the last 40 years were in line with the long-term historical average. Bond returns, though, were much higher than their historical averages and their current yields. This high bond return, the researchers explain, stems from higher interest rates in the 1970s and a subsequent declining interest rate environment. Such a scenario for bonds is very unlikely to repeat itself in the future, given today's low interest rate environment.

Their conclusion: "Investors hoping bonds will outperform in the coming years will likely be disappointed," they say.

Bonds can outperform stocks over a long period, Chen and Ibbotson add, but investors need almost perfect timing to get in and out of the market to realize such returns. "We believe the right strategy is to follow a disciplined asset-allocation policy that considers the return and risk tradeoffs by taking advantage of the diversification benefits between stocks and bonds over time," they conclude.

The Morningstar report also draws attention to the words of Warren Buffett: "When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary."